7 Fallacies of Economics

When this was written in 1981, Mr. Reed was Assistant Professor of Economics at Northwood Institute in Midland, Michigan and Director of the college’s summer Freedom Seminars. Today he is the president of the Foundation for Economic Education

A news commentator once observed that “any half-dozen economists will normally come up with about six different policy descriptions.”

It certainly does seem that way! If economics is a “science,” then why does it defy the precision, the certainty, and the relative unanimity of opinion which characterize so many other sciences—physics, chemistry, and mathematics, for instance?

If laws of economics and human action exist and are immutable, why do we find economists all over the board on matters of critical importance? Economist A champions a tax cut while Economist B favors a tax increase. Economist C argues for tariff protection but Economist D calls for free trade. Another economist proposes socialization and is opposed by yet another who advances the market economy. Indeed, if there is anything which all economists can agree on, it is that, well, they disagree.

Perhaps the cynic will glance at this economic Tower of Babel and condemn the study of anything economic. But that would be unfair to the many eternal truths which do exist in the field of human interaction in the marketplace. Such a view, moreover, is what some would call a “cop- out.” It offers no plausible explanation for the confusion and no guides for sorting out what is correct from what is incorrect.

Yes, there are methods to the “madness” of economists. The fact that they do not all think alike is capable of explanation. Where might we start?

First, economics is simply not physics, chemistry, or mathematics. It is the study of human action, and humans are not programmed robots. Yes, certain immutable laws of nature do indeed exist, but one of them is that humans are—each and every one of them inner-motivated, creative, self-interested organisms. They range from docile to irascible, meek to daring, complacent to ambitious, smart to not-so-smart. As Adam Smith pointed out more than two hundred years ago, “In the great chessboard of human society, every piece has a principle of motion of its own, altogether different from that which the legislature might choose to impose upon it.”

This inherent variability can easily give rise to dissent among those observing it and it can just as easily confound the predictions of those bold enough to place a mathematical handle on it.

Being individuals themselves, economists will differ in their value and ethical judgments. One who is a socialist will differ on a policy matter with one who is a libertarian. They may even agree on the outcome of that policy while disagreeing on whether that outcome is “good” or “bad.” People who are well-intentioned and truth-seeking yet operating from divergent ethical premises frequently arrive at divergent conclusions.

In addition, economists may dis-agree because they have different data or insufficient data or no reliable data at all.

These are some, and I am sure not all, of the reasons why good economists may clash. The purpose of this essay, however, is to look for reasons for economic confusion in another direction. In brief, economists clash because, as Henry Hazlitt has so succinctly put it, “Economics is haunted by more fallacies than any other study known to man” (emphasis mine).

Is there such a thing as “bad economics?” You bet there is, just as surely as there is good plumbing and bad plumbing. If one means by “bad economics” the promotion of false reasoning, mistaken assumptions, and shoddy intellectual merchandise, then Hazlitt’s comment ought to be enshrined as a law!

It may be an oversimplification, but I believe that the essence of”bad economics” can be distilled into the following seven fallacies. Each of them is a pitfall which the good economist will faithfully bypass.

1. The fallacy of collective terms.

Examples of collective terms are “society,” “community,” “nation,” “class,” and “us.” The important thing to remember is that they are abstractions, figments of the imagination, not living, breathing, thinking, and acting entities. The fallacy involved here is presuming that a collective is, in fact, a living, breathing, thinking, and acting entity.

The good economist recognizes that the only living, breathing, thinking, and acting entity is the individual. The source of all human action is the individual. Others may acquiesce in one’s action or even participate, but everything which occurs as a consequence can be traced to particular, identifiable individuals.

Consider this: could there even be an abstraction called “society” if all individuals disappeared? Obviously not. A collective term, in other words, has no existence in reality independent of the specific persons which comprise it.

It is absolutely essential to determine origins and responsibility and even cause and effect that economists avoid the fallacy of collective terms. One who does not will bog down in horrendous generalizations. He will assign credit or blame to non-existent entities. He will ignore the very real actions (individual actions) going on in the dynamic world around him. He may even speak of “the economy” almost as if it were a big man who plays tennis and eats corn flakes for breakfast.

2. The fallacy of composition.

This error also involves individuals. It holds that what is true for one individual will be true for all others.

The example has often been given of one who stands up during a football game. True, he will be able to see better, but if everyone else stands up too, the view of many individual spectators will probably worsen.

A counterfeiter who prints a million dollars will certainly benefit himself (if he doesn’t get caught) but if we all become counterfeiters and each print a million dollars, a quite different effect is rather obvious.

Many an economics textbook speaks of the farmer who is better off because he has a bumper crop but may not be better off if every farmer has one. This suggests a widespread recognition of the fallacy of composition, yet it is a fact that the error still abounds in many places.

The good economist neither sees the trees and ignores the forest nor sees the forest and ignores the trees; he is conscious of the entire “picture.”

3. The fallacy of “money is wealth.”

The mercantilists of the 1600s raised this error to the pinnacle of national policy. Always bent upon heaping up hoards of gold and silver, they made war on their neighbors and looted their treasures. If England was richer than France, it was, according to the mercantilists, because England had more precious metals in its possession, which usually meant in the king’s coffers.

It was Adam Smith, in The Wealth of Nations, who exploded this silly notion. A people are prosperous to the extent they possess goods and services, not money, Smith declared. All the money in the world—paper or metallic—will still leave one starving if goods and services are not available.

The “money is wealth” error is the affliction of the currency crank. From John Law to John Maynard Keynes, great populations have hyperinflated themselves to ruin in pursuit of this illusion. Even today we hear cries of “we need more money” as the government’s monetary authorities crank it out at double digit rates.

The good economist will recognize that money creation is no short-cut to wealth. Only the production of valued goods and services in a market which reflects the consumer’s wishes can relieve poverty and promote prosperity.

4. The fallacy of production for its own sake.

Although production is essential to consumption, let’s not put the proverbial cart before the horse. We produce in order that we may consume, not the other way around.

I enjoy writing and teaching but I enjoy sunning in Acapulco even more. I have labored to produce this piece and to teach its principles in my classes instead of going to Acapulco first because I know that’s the only way I’ll ever get out of Michigan. Writing and teaching are the means; sunning in Acapulco is the end.

A free economy is a dynamic economy. It is the site of what the economist Joseph Schumpeter called “creative destruction.” New ideas supplant old ideas, new products and methods replace old products and methods, and whole new industries render obsolete old industries.

This occurs because production must constantly change shape to conform with the changing shape of consumer demand. As Henry Hazlitt has written, “it is just as necessary to the health of a dynamic economy that dying industries be allowed to die as that growing industries be allowed to grow.”

A bad economist who falls prey to this ancient fallacy is like the fabled pharaoh who thought pyramid-building was healthy in and of itself; or the politician who promotes leaf-raking where there are no leaves to be raked, just to keep people “busy.”

It seems that whenever an industry gets in trouble, some people cry that it must be preserved “at all costs.” They would pour millions or billions of dollars in subsidies on the industry to prevent the market’s verdict from being heard. The bad economist will join the chorus and ignore the deleterious impact that would befall the consumer.

The good economist, on the other hand, does not confuse ends with means. He understands that production is important only because consumption is even more so.

Want an example of this fallacy at work? How about the many proposals to prevent consumers from buying Japanese autos in order to “protect” the American auto industry from competition?

5. The fallacy of the “free lunch.”

The Garden of Eden is a thing of the distant past yet some people (yes, even some economists) occasionally think and act as if economic goods can come with no cost attached. Milton Friedman is one economist who has warned repeatedly, however, that “there is no such thing as a free lunch!”

Every “something for nothing” scheme and most “get rich quick” plans have some element of this fallacy in them. Let there be no mistake about this: if economics is involved, someone pays!

An important note here regards government expenditures. The good economist understands that government, by its very nature, cannot give except what it first takes. A “free” park for Midland, Michigan is a park which millions of taxpaying Americans (including Midlanders) actually do pay for.

A friend of mine once told me that all one needs to know about economics is “What is it going to cost and who is going to pay for it?” That little nutshell carries a kernel of advice for the economist: don’t be superficial in your thinking!

6. The fallacy of the short run.

In a sense, this fallacy is a summary of the previous five.

Some actions seem beneficial in the short run but produce disaster in the long run: drinking excessively, driving fast, spending blindly, and printing money, to name a few. To quote the venerable Henry Hazlitt again, “The bad economist sees only what immediately strikes the eye; the good economist also looks beyond. The bad economist sees only the direct consequences of a proposed course; the good economist looks also at the longer and indirect consequences.”

Politicians seeking to win the next election frequently support policies which generate short- run benefits at the expense of future costs. It is a shame that they sometimes carry the endorsement of economists who should know better.

The good economist does not suffer from tunnel vision or shortsightedness. The time span he considers is long and elastic, not short and fixed.

7. The fallacy of economics by coercion.

Two hundred years after Adam Smith, some economists still have not learned to apply basic principles of human nature. These economists speak of “increasing output” but prescribe the stick rather than the carrot to get the job done.

Humans are social beings who progress if they cooperate with one another. Cooperation implies a climate of freedom for each individual human being to peacefully pursue his own self- interest without fear of reprisal. Put a human in a zoo or in a strait jacket and his creative ener gies dissipate.

Why did Thomas Edison invent the light bulb? It was not because some planner ordered him to!

Take a look around the world today and you see the point I am driving at. Compare North Korea with South Korea, Red China with Taiwan or Hong Kong, or East Germany with West Germany.

One would think, with such overwhelming evidence against the record of coercion, that coercion would have few adherents. Yet there are many economists here and abroad who cry for nationalization of industry, wage and price controls, confiscatory taxation, and even outright abolition of private property. One prominent former U.S. senator declared that “what this country needs is an army, navy, and air force in the economy.”

There’s an old adage which is enjoying new publicity of late. It reads, “If you encourage something, you get more of it; if you discourage something, you get less of it.” The good economist realizes that if you want the baker to bake a bigger pie, you don’t beat him up and steal his flour.

Well, there you have it—not the final answer to confusion in economics, but at least a start. I for one am convinced that good economics is more than possible. It is imperative, and achieving it begins with the knowledge of what bad economics is all about.

ABOUT

Lawrence W. (“Larry”) Reed became president of FEE in 2008 after serving as chairman of its board of trustees in the 1990s and both writing and speaking for FEE since the late 1970s. Prior to becoming FEE’s president, he served for 20 years as president of the Mackinac Center for Public Policy in Midland, Michigan. He also taught economics full-time from 1977 to 1984 at Northwood University in Michigan and chaired its department of economics from 1982 to 1984.

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December 2014

Unfortunately, educating people about phenomena that are counterintuitive, not-so-easy to remember, and suggest our individual lack of human control (for starters) can seem like an uphill battle in the war of ideas. So we sally forth into a kind of wilderness, an economic fairyland. We are myth busters in a world where people crave myths more than reality. Why do they so readily embrace untruth? Primarily because the immediate costs of doing so are so low and the psychic benefits are so high.